The IRA Job Machine

Kip T. Tobin lives in Akron, Ohio, and in 2003 he found himself out of a job after working 20 years for a rubber importer. Rubber City, as Akron is still called, had by that time shed most of its traditional tire industry and been reduced largely to Goodyear. Tobin needed a new career.

Instead of seeking another perch inside the corporate ranks, Tobin attended a franchise fair in Washington, D.C., and in June 2005 acquired the Akron franchise of Express Employment Professionals, an employment agency. The franchise license cost Tobin $25,000, and he was expected to invest another $130,000 to $175,000 to get it off the ground.

Tobin didn't have that much available in ready cash, but he did have an IRA worth much more. He could have cashed it in, paying ordinary income tax and a 10% early distribution penalty. Not an appealing prospect. Instead, Tobin, at the employment company's suggestion, went to a specialist broker who, through a series of complicated legal transactions, arranged for him to use his tax-deferred savings account to finance his new business--without the money first being distributed and taxed.

Today Tobin and two other employees are gainfully employed finding work for professionals in the Akron area precisely because he was able to crack his IRA penalty-free to start a new business.

"Look how many new businesses are getting started by having this [IRA-tapping] program available," he says. "I know how many people we put to work through our services. It is a win-win situation."

Win-win, perhaps, but there is a risk. The Internal Revenue Service has recently expressed concerns about the technique. This method of financing start-ups has been around--and controversial--for some time. Forbes first looked at the pros and cons of using retirement accounts to finance businesses in 2004. Our advice: Entrepreneurs interested in the method should split their IRAs into two, one to invest in the new business and the other to manage a diversified retirement portfolio separate from the new business and associated risks.

With little credit available to entrepreneurs in the recession, the method, known as a "Rollover as Business Start-ups," has become much more popular recently. While there are no statistics on just how common the practice is, Leonard Fischer, founder of BeneTrends, one of the oldest and largest specialists brokering such transactions, says he and his staff of 30 are currently doing 100 transactions a month, up 50% over the past year. A transaction typically works like this:

The owner of the account creates a "C" corporation, which then adopts an off-the-shelf 401(k) plan. Employees of the new company are allowed to roll funds over from their personal IRAs into its 401(k). The corporation then issues stock and establishes a qualified profit-sharing plan that allows employees to exchange assets in their 401(k)s for that stock. Voilà, the proprietor has financed and owns his business without having made any taxable withdrawals.

BeneTrends and other big brokers charge about $5,000 to set up one of these plans and another $1,000 a year in annual maintenance and filing charges. Reputable brokers provide written guarantees that they will fight the IRS on their dime if it ever challenges the client's transactions. An additional protection would be to get an outside tax accountant or lawyer to vet the setup and to privately apply to the IRS for a favorable opinion letter or "determination."

Guidant Financial Group is another big player in the industry, which, according to the IRS, now includes nine major firms. A simple
Google
search will spit out a long list of such specialist brokers, big and small, offering such IRA-cracking services for small business purchases. By BeneTrends estimates, tens of thousands of such transactions have been completed, and many of those who have completed them have favorable IRS determination letters in hand.

Last year, the IRS even set up a "pre-approved opinion letter program," opening a two-year window through which promoters of the technique can provide clients, on an industrial scale, with a "favorable opinion letter" from the IRS. Clients must, of course, minutely follow the promoters' pre-approved master plan of administration; even slight deviations usually require a new determination letter as "an individually designed plan."

In October, however, this fast-growing industry got a shot across the bow in the form of an IRS memorandum. Labeling this "Rollover as Business Start-ups" system with the alarming acronym ROBS, the IRS officially trumpeted a newfound hostility to the financing technique. While the IRS memo conceded that ROBS "serve legitimate tax and business planning needs," it urged case-by-case scrutiny for violations of rules governing retirement accounts.

Among the issues that the IRS singled out that might allow an auditor to disallow the rollover are "operational defects" that mostly occurred in the later years of running a ROBS. For example, a failure to: properly file annual accounts, notify employees that the company's stock ownership program was available to all employees, or get the firm adequately appraised at key points in its development (for the purpose of valuing the stock being sold to the 401(k)). All such infractions might be the basis for future IRS attacks. Other no-nos include using the retirement-funded assets of the corporation for personal and non-business purposes, such as buying an RV, as one ROBS user apparently did.

Bottom line, strict compliance with back-end documentation and procedures in later years is crucial if small-business proprietors are to avoid the risk of coming out of an IRS audit with their entire 401(k) disqualified--leading to the immediate taxation of all rolled-over IRA money, plus the possibility of penalties and destruction of their business.

Back of the envelope appraisals don't wash either. Instead, they must be properly compliant, independent and fully documented. That means a more costly third party "valuation," rather than the less rigorous third party "appraisal." The IRS memo highlighted cases where in later years they found "an appraisal may be created to substantiate this value, but it is often devoid of supportive analysis. We find this may create a prohibited transaction, depending on true enterprise value." (The IRS defines a "prohibited transaction" as a transfer of assets or income from a plan to beneficiary or "disqualified" person.)

Another critical point, say experts parsing the IRS memo, was the warning that an employee-stock option program run through a company 401(k) must be available to all employees, not just the founders. In some cases, the IRS found "employees in some arrangements have not been notified of the existence of the plan, do not enter the plan or receive contributions or allocable shares of employer stock." As one tax specialist pointed out, however, many ROBS are used to finance one-man businesses, making that a moot point.

Instead, what the IRS appear to be on the lookout for, not unreasonably, are scoundrels who set up a ROBS solely to enrich themselves, when the law requires that the employee stock purchase program at the core of a ROBS is equitably available to all employees.

The expressed view among advocates of the ROBS technique is that the IRS memo was, for all its saber rattling, oddly reassuring. In fact, BeneTrends' Fischer claims it had the opposite effect of what the IRS appears to have intended. Namely, instead of discouraging the use of ROBS, it provided a road map of the late-stage procedural issues brokers need to monitor closely in order to keep ROBS compliant.

Among some observers, there is still a degree of irritation with the IRS' hostility to a technique that's been used to start businesses and generate jobs.

"ROBS is not an abusive use of retirement plan funds. If the IRS doesn't like ROBS, it should ask Congress to outlaw them," Natalie Choate, a respected Boston attorney and IRA expert, wrote in Steve Leimberg's Employee Benefits and Retirement Planning Newsletter. "However, it seems unlikely that Congress would do so at a time when the use of retirement plan funds to start new enterprise must be seen as a blessing to the nation."

Fischer is more pointed still. "Even the IRS has to follow the law," he says.